Small island, big finger

Cyprus’s rejection of a bail-out plan raises new doubts about the future of the euro

CALL it the cussedness of an island nation. Beneath the cheeriness of Aphrodite’s sun-kissed island lies the intransigence of the Balkans and the Middle East. On the eve of its accession to the European Union in 2004, the Greek-Cypriot republic rejected a UN plan to reunite with the Turkish-Cypriot north, where the plan was supported. Within the club the Greek-Cypriot government has used and abused EU institutions to wage its feud with Turkey and to lend support to Russia.

This week’s 36-0 vote in the Cypriot parliament to reject a euro-zone bail-out, in protest at a large proposed tax on bank deposits, may be the most momentous act of bloody-mindedness yet, raising new questions about the stability, and even the survival, of the euro. Outside parliament, a demonstrator’s poster summed up the mood: “Fuck Europe”. Such defiance from the island will be admired by some, yet it does not alter Cyprus’s predicament. It is bust, and cannot afford to salvage its oversized and insolvent banks (see article). Cyprus is also trying to play the euro zone against Russia, amid rumours that it might be prepared to offer Russia concessions in offshore gasfields or a naval base.

But who really holds the gun—the firing squad, or the prisoner? The question was raised in Greece last year, and leaders decided to keep it in the euro, even at the cost of overt and covert debt-forgiveness. Cyprus is even smaller, accounting for just 0.2% of euro-zone GDP. Yet Eurocrats insist it too is of “systemic” importance. A bank run in Cyprus could start one in other countries with dodgy banks. And the prospect of Cyprus’s exit from the euro would raise doubts about the future of other weak members of the currency.

For now, the Eurocrats say it is up to Cyprus to come up with an alternative plan. Perhaps they think Cyprus will have to come to its senses if it is ever to reopen its banks. And if it remains obstinate, some would see advantage in making an example of the Cypriots. To euro-zone hawks, the spread of moral hazard is the most dangerous form of contagion.

In many ways, the mess in Cyprus comes down to the political symbolism of round numbers. Germany said the euro zone would lend no more than €10 billion ($13 billion) to recapitalise Cyprus’s banks and refinance its debt. The IMF insisted the island’s debt should be kept below 100% of GDP by 2020. And Nicos Anastasiades, the new president of Cyprus, was adamant that any tax levied on big depositors should be kept below 10%. Put crudely, the euro zone and the IMF ensured the bail-out should be accompanied by a bail-in of depositors; but Cyprus chose to inflict much of the pain on grandmothers’ savings so as to limit the losses of Russian oligarchs.

As so often, short-term politics has trumped rational crisis-management. The deal in Cyprus should have been a dry run for the banking union that the euro zone seeks to create. Instead it has raised questions about whether Europeans genuinely intend to break the link between weak banks and weak sovereigns.

Take deposit guarantees. In the early days of the financial crisis the EU raised deposit insurance to €100,000 to prevent bank runs. Now it risks provoking them by seeming to breach that guarantee. National deposit insurance is plainly limited by the solvency of the state. A common deposit-guarantee system in the euro zone makes sense, however much the Germans and Eurocrats may claim it is irrelevant.

Then look at the promise of a common means of winding down troubled banks. Uniform bank-resolution rules were supposed to be adopted in each EU country, and later on a unified system was due to be created for the euro zone. The Cyprus deal makes a mockery of the proposed hierarchy of creditors to absorb bank losses: senior bondholders (few in the case of Cyprus) have been spared but small depositors penalised.

With a proper banking union, other options become possible. One is the orderly wind-down of Cyprus’s two big crippled banks. This would impose heavier losses on large deposits (up to 50%), but protect small savers and shrink the banking sector. Another option would be the direct recapitalisation of banks by the euro zone. And with a less rickety banking system, it would be easier to get tough with rule breakers.

Draghi’s dilemmas

Amid the muddling of European leaders, Mario Draghi, boss of the ECB, has stood out as the prime guarantor of the euro. His conditional promise to buy the bonds of vulnerable sovereigns did much to restore calm last year, though it has never been tested. The ECB, moreover, is being charged with overseeing a new single euro-zone bank supervisor. Its jealously guarded independence is supposed to lend credibility to the system. Yet the more the ECB involves itself in managing the crisis, the more it sullies itself with politics. And having been intimately involved in the botched plan for Cyprus’s banks, and insisted on the protection of senior bondholders, it is reasonable to question whether the ECB is up to the task of bank supervision.

There is another question: now that voters in Italy and MPs in Cyprus have openly rejected the strictures of the euro zone, might the ECB’s magic spell be broken? After all, its bond-buying policy depends crucially on troubled countries submitting to a euro-zone reform programme. The ECB may reach a decisive moment sooner. Cyprus’ banks survive only on the ECB’s emergency liquidity. If there is no deal in Cyprus, the ECB will have to decide whether to follow through on its ultimatum to cut off the money within days. This would cause a messy collapse and almost certainly push Cyprus out of the euro. Mr Draghi has bravely stepped in to defend the weakest members of the euro zone. But would he dare to shoot one of his own?